Private Credit: Rise, Risks, and Returns in a Changing Market

Private credit is one of the hottest asset classes today. Recently, a colossal $4.25 billion acquisition of a Baxter International Inc. division was financed not through conventional channels like banks, but through private credit supplied by entities like Ares Management, Blackstone, Blue Owl Capital, and HPS Investment Partners. Investors piling into private credit are being seduced by higher returns and seemingly lower risk.

But, what exactly is private credit, and why is it so popular with both investors and borrowers alike? Is private credit a good investment? Or, should you avoid the private credit hype?

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Understanding Private Credit

Private credit is essentially a form of lending where specialized asset managers provide loans to businesses. Unlike traditional banks, these lenders often customize loans for each borrower and do not trade the debt. Flush with capital, private credit funds are doling out loans at advantageous rates. Private credit as an asset class has come into prominence in recent years, especially after the Dodd-Frank Act of 2010 nudged riskier lending outside the banking sector.

Private credit closely resembles private equity – both pool capital from investors, such as pension funds and insurance companies. However, while private equity firms often acquire partial or complete ownership of companies, private credit firms simply lend money, putting themselves first in line for repayment if the borrower defaults.

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The Meteoric Rise

The private credit market has witnessed explosive growth in recent years. According to Preqin Ltd, the global private debt grew from just over $300 billion at the end of 2010 to a staggering $1.5 trillion as of September 2022. Moreover, projections indicate that this number could reach $2.2 trillion by 2027.

One factor behind this burgeoning growth is the search for higher yields. With interest rates at historical lows until recently, investors were on the lookout for more lucrative opportunities. Private credit emerged over the past two decades as the golden goose, offering attractive returns compared to other investments. For instance, the Cliffwater Direct Lending Index, which represents around $280 billion of private loans to small and midsize companies, was up by 6.29% in 2022, a year when the S&P 500 experienced a loss of about 19%.

Murky Waters

However, non-traditional lending is not without its challenges and concerns. Firstly, these loans often have floating interest rates. While this can lead to higher returns for investors as rates rise, it can also increase the repayment burden on borrowers, potentially raising the risk of default.

Secondly, there is a significant issue with transparency. Since these loans are typically held until maturity, lenders have considerable discretion in valuing them. This can result in overly optimistic valuations, potentially masking troubled investments within these funds.

Additionally, the regulatory framework for non-traditional lending is less developed compared to the traditional banking sector. Although the Federal Reserve does not currently view this lending as systemically risky, the lack of transparency makes it challenging to accurately assess risks to the broader financial system.

Is the Tide Turning on Private Credit?

As the excitement around non-traditional lending reaches its peak, investors should proceed with caution. With rising defaults, opaque valuations, and limited regulatory oversight, this market is navigating uncertain terrain.

Additionally, it is crucial for regulators and policymakers to closely monitor this growing sector. The lack of scrutiny compared to traditional banks has intensified calls for increased disclosure and oversight.

Alarmingly, non-traditional lending funds are now being marketed to average investors through retail brokerage channels. Many investment advisors are promoting these funds (along with other private market investments) as a means to “beat the market.” However, it raises the question: how robust can the returns be when such “exclusive” investments are becoming widely accessible?

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Growth of Private Credit

Private credit became supercharged following the 2008 financial crisis and passing of the Dodd-Frank Act which limited the ability of banks to make certain types of loans. Regulators were trying to ensure banks and other regulated financial institutions didn’t get mixed up in risky corporate lending. Since, such risky loans could pose risks to the broader financial system.

The result of these regulatory changes was a shift away from regulated banks towards private credit. Private credit funds filled the gap left by traditional commercial bank lending. Seizing the opportunity, private credit funds raised money directly from investors to make loans directly to companies; by-passing the regulated financial system and earning high fees in the process.

A Boom for Private Credit

Over the course of the past two decades, private credit has boomed. Investors have become increasingly enthusiastic about funding private credit funds because the returns seem so good while the risks also seem lower.

However, these returns have been earned during a low interest rate environment when credit risks have been benign. Many private credit funds have not been tested during a recession.

Do Investors Understand the Risks?

With interest rates now rising again, the pressure on many private credit funds is mounting. Unfortunately, most investors are unaware of this new reality. Partly because many private credit funds hold their loans to maturity. They typically don’t mark those loans to market based on their current value. Such a valuation practice paints a rosy picture of the true nature of such lending. And, keeps many private credit investors in the dark; until its too late.

Private Credit Investors: Pension Funds

Who have been the most enthusiastic private credit investors? Pension funds. Partly because many pension funds are trying to earn their way out of funding deficits, they are taking on more risk then is prudent.

Pensions also love private credit because it seems like a good way to beat traditional bond markets. Egg-head employees working for pension funds seem to forget that a free lunch never exists.

Private Credit Investors: Family Offices

Why might family offices be so enthusiastic about private credit? Partly, they’re caught up in the hype. But, also due to the potential for higher fees. If investing were as simple as holding a diversified portfolio of stocks, bonds, and real estate, then why would anyone need to pay high fees for fancy investment advice?

What Are the Risks?

For investors, the risks associated with non-traditional lending are twofold. Firstly, as interest rates rise, the value of many loans is likely to decrease. Many of these funds do not mark-to-market, meaning their true value might be significantly lower than investors assume. Secondly, such investments are often illiquid, making them difficult to sell. While sellers may tout the “illiquidity premium” as a benefit that leads to higher returns, the reality is that these funds could be left holding bad debt if credit conditions worsen during an economic downturn.

End of Easy Money

With easy money coming to an end, and interest rates rising, we’ll soon see which investors are swimming naked. Higher interest rates and an economic downturn could spell disaster for many private credit funds. Borrowing costs will increase, and as a result, interest payments on floating-rate loans will also rise. While this could lead to higher returns for investors initially, it might also increase the risk of borrower defaults.

Private Credit: Regulatory Scrutiny

As market conditions evolve, regulatory bodies are focusing more on non-traditional lending sectors. Increased regulatory scrutiny and new lending regulations will affect the operations and returns of these lending providers.

Managers of non-traditional lending funds may face pressure from both directions. On one hand, the market is providing lower returns, which may reduce investor demand. On the other hand, lawmakers are intensifying their examination of how these funds are regulated, leading to higher regulatory costs.

Conclusion

Do you need private credit in your investment portfolio? Probably not. Most financial goals can be achieved using a traditional mix of stocks, bonds, and real estate. If you’re an investor with an impact mandate, you should probably focus on more targeted investments towards innovative funds & businesses that promote your specific values. Private credit as an asset class will not necessarily satisfy your impact investing goals.

Non-traditional lending, which has seen rapid growth over the past decade, is now at a critical juncture. Initially viewed as a lucrative alternative to traditional banking, it has attracted significant interest from investors, including pension funds and family offices. However, as we move away from an era of easy money, the landscape for these investments is shifting.

Rising interest rates present a dual challenge: while they could initially lead to higher returns, they also increase the risk of borrower defaults. Combined with the lack of transparency in valuations and the fact that many of these funds have yet to face a recession, caution is warranted for investors.

Furthermore, as these investments become more accessible to average investors, the stakes are higher. The sector, which has operated with relatively few regulatory constraints, is likely to encounter increased scrutiny. This is necessary to ensure fair competition and protect investors.

For both institutional and retail investors, understanding the evolving dynamics and risks associated with non-traditional lending is crucial. Diversification, thorough due diligence, and a realistic assessment of risks and rewards are essential. While these investments can still be a valuable part of a diversified portfolio, traditional bond markets, known for their liquidity and transparency, should also be considered.

Non-traditional lending has established itself as a significant player in finance, but it now faces the challenge of adapting to changing financial conditions. Through careful management, informed investment decisions, and regulatory oversight, it can maintain its role in the investment landscape. However, the current enthusiasm for these investments should give way to a more measured and cautious approach.

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